How We Choose Funds for our Clients’ Investment Portfolios

The Dow Jones Industrial Average has just passed 23,000 as I am writing this newsletter. Clients typically ask if there are any good places to invest, and this topic comes up more frequently when the stock market is making a new high. Rather than talk about the typical cycle of the market, I want to focus this newsletter on investment selection. Specifically, how we choose funds for our clients’ portfolios.

Anyone who has ever read a mutual fund advertisement has probably noticed the disclaimer “Past performance is no guarantee of future returns.” A study[1] by Standard & Poor’s found that only 5% of funds in the top 25% of their category for the past year manage to stay in the top 25% three years in a row. If not performance, what criteria should be used?

Criteria We Use to Choose Funds

Expenses

Mutual funds cost money to run and administer. Even passively managed index funds have expenses. We look at the expense ratio of a fund and compare it to the category average. Our objective is to select the fund with the lowest possible expense ratio for our clients if all else is equal. Expenses are shown in mutual fund data as a percentage of assets. If two mutual funds investing in the same category have expense ratios of 0.50% and 1.5%, respectively, the chance of the second fund outperforming the first fund consistently by a full percentage point each year is remote.

Turnover cost

The cost of trading positions within the fund is not included in the expense ratio. This cost is a drag on performance and creates additional expense in the form of taxes for a fund held in a taxable account. Transaction costs have been estimated[2] to generally average 0.6%. A fund with a turnover ratio of 100 has an estimated trading expense of 1.2%, 0.6% to sell everything, and another 0.6% to replace the positions. All things being equal, we choose funds with low turnover to minimize expenses.

Broad diversification

We diversify portfolios over different asset classes by choosing a fund to represent a specific asset class. Therefore, the fund we select must be broadly diversified within the asset class. We avoid funds that are concentrated within an industry or an individual company. We also avoid funds that use leverage which increases risk and volatility.

Active management vs. passive

Passively managed funds (often referred to as index funds, although not all track an index) have a lot of advantages. The average expense ratio of a passive fund is 0.11%, while the average for actively managed funds is 0.84%[3]. Passively managed funds typically have low turnover and are therefore more tax efficient. Most passive funds are broadly diversified as they attempt to track an index that is specific to an asset class. Why invest in anything else?

In reality, actively managed funds may bring significant benefits when used properly in the construction of a portfolio. Actively managed and passive index funds are complementary when used together.

Generally, active funds do better than passive funds when markets are inefficient[4].

A skilled manager can take advantage of illiquid and data-inefficient markets, where mispricing of securities can be frequent and the rewards usually more substantial. Some who believe index funds are the only way to invest believe there are few inefficiencies in today’s market. This may be true of large cap stocks. However, markets for small-cap and microcap stocks can be inefficient due in part to scarce guidance by analysts. This is where we have found active management to work well for our clients’ portfolios.

International and developing markets are other areas where we might find market inefficiencies. Diversification across international markets is essential to proper asset allocation. A blanket approach using index funds doesn’t usually take advantage of unique opportunities that arise within the international markets as effectively as a skilled fund manager.

Periods of market stress also appear to favor active management over passive. A study[5] by Fidelity Investments found that actively managed funds do better when markets are under pressure. This actually makes perfect sense. One of the reasons passively managed funds typically do better over time is because the stock market goes up over time. Passively managed funds must stay 100% invested in order to track their index. According to an article in Barron’s[6], actively managed funds are rarely 100% invested. The average cash position of actively managed funds was 3.6%. Cash would hold back the performance of a fund when the market is going up. However, cash would be quite helpful when the market is going down. The Fidelity study also concluded, “We think this outperformance is likely due to active managers’ ability to select market-beating stocks even when the market is going down, or to reduce losses by holding lower stock exposure before a sell-off.”

In conclusion, passively managed funds have important advantages and play a central role in portfolio construction for many reasons. Actively managed funds are also an important tool and, when used together with passive funds, have the potential to minimize risk.

Rick’s Tips:

All funds have expenses. Expense ratios are an important tool to compare two funds with the same investment strategy.

Trading costs are not included in expense ratios. You must look at turnover to estimate this cost.

A recent Fidelity study found that actively managed funds generally performed better than index funds in down markets.

[1]Does Past Performance Matter? The Persistence Scorecard. By Aye M. Soe, CFA. S&P Dow Jones Indices, June 2014.[2]Bogle On Mutual Funds: New Perspectives For The Intelligent Investor. By John Bogle. Wiley Investment Classics. April 2015[3] Source: Index Funds vs. Mutual Funds. By Jordan Wathen. The Motely Fool. August 2016[4] The Experts: When Does Active Management Make Sense? The Wall Street Journal. April 2013[5] Rocky markets and the power of active funds. Fidelity Viewpoint. August 2017[6] For Mutual Funds, How Much Cash Is Too Much? By Lawrence Strauss. November 2014